Has demand for ESG disclosure reached an inflection point?

Do investors really care about ESG (environmental, social and governance) disclosures? Apparently they do, according to a recent survey by EY, and they even take information about ESG into account in making investment decisions. At times, robust corporate attention to ESG is, to some extent, even read to signify sound operational practices overall. Looking at data over several years, EY found that there was a global trend toward increased interest in nonfinancial information on the part of investment professionals as well as an enhanced focus on ESG factors, albeit an informal one, in the investor decision-making process. In sum, EY suggests that demand for ESG information has reached an inflection point. But are companies satisfying that demand?

EY surveyed over 320 institutional investors, one-third of which had over $10 billion in assets under management, about the importance of nonfinancial reporting, in particular, the role ESG analysis plays in their investment decision-making.

Those surveyed broadly concurred that ESG factors play a key role in achieving sustainable returns. For example, 93% of investors either agreed or strongly agreed that “[o]ver the long term, ESG issues — ranging from climate change to diversity to board effectiveness — have real and quantifiable impacts.” In particular, the report observes, “serious reputational and environmental risks can and do surface, and they can have very real impacts on the bottom line.” According to one investor cited in the survey report, “ESG factors can help in identifying new opportunities and in managing long-term investment risks, avoiding poor company performance that can come from lax governance, or from weak environmental or social practices….” Various research studies cited in the report supported the case that “solid ESG practices at companies lead to better operational performance, and that 80% of the studies analyzed showed that a company’s stock performance is positively influenced by good sustainability practices.”

EY also found that investors broadly supported the ESG themes expressed in the 2016 letter from the Chair and CEO of BlackRock, including the call for an annual board-approved strategic framework for long-term value creation.

SideBar: BlackRock CEO’s 2016 letter, in addition to a focus on long-term value creation, also urged companies to increase their focus on ESG issues, such as climate change, diversity and board effectiveness, which “offer both risks and opportunities” and “have real and quantifiable financial impacts.” Addressing these issues effectively can be “a signal of operational excellence,” the letter contends, and BlackRock is in the process of integrating these considerations into its investment process. (See this PubCo post.) That theme was echoed in the 2017 letter, which advocated that companies be responsible members of their communities, considering ESG factors such as “sustainability of the business model and its operations, attention to external and environmental factors that could impact the company, and recognition of the company’s role as a member of the communities in which it operates. A global company needs to be local in every single one of its markets.” Moreover, from a shareholder’s perspective, ESG factors “can provide essential insights into management effectiveness and thus a company’s long-term prospects.” (See this PubCo post.)

Analyzing information over a three-year period, EY concludes that ESG factors have reached an inflection point, playing an increasingly influential role in investment decision-making. Interestingly, EY contends that ESG analysis has shifted over time from a primary focus on corporate governance issues to a now equal interest in environmental issues, particularly climate change. EY’s surveys showed that the percentage of investors that, in the previous 12 months, considered nonfinancial performance to have frequently or occasionally played a pivotal role in their investment decisions increased to 68% in 2016 from 52% in 2015 and 58% in 2013. In addition, the proportion of investors that dismiss nonfinancial and ESG information as immaterial or trivial declined in 2016 to 16% from 52% in 2015 and 60% in 2013. Moreover, it appears that a risk or history of poor governance or human rights violations is an immediate disqualifier for a significant proportion of investors: with respect to poor governance, 39% of those responding in 2016 would immediately rule out an investment, compared to 27% in 2015 and 30% in 2013. Similarly, human rights issues would have the same disqualifying effect on 32% of respondents in 2016, compared to 19% in 2015 and 22% in 2013.

So are companies paying adequate attention to ESG issues and providing the ESG information that investors want to see? Maybe not. Of those surveyed, 82% either agreed or strongly agreed that “[e]nvironmental and social issues offer both risks and opportunities, but for too long, companies have not considered them core to their businesses.” And this year, 60% of those surveyed did not think that companies adequately disclosed their ESG risks, an increase of more than 20 percentage points over the prior year: according to EY, the “majority of investors surveyed are disappointed by today’s disclosures. They often believe disclosures aren’t adequately linked to material risks and opportunities, they don’t reflect the full value of businesses, or clearly articulate environmental and social challenges and that reporting would benefit from being more integrated.” Unpacking that conclusion a bit, EY found a “troubling dissatisfaction among investors with the quality of information available from issuers,” with 42% of respondents in 2016 indicating that “nonfinancial information is often inconsistent, unavailable or not verified, up from 32% in 2015 and 20% in 2013.” Over 80% indicated that companies did not adequately disclose ESG risks that could affect their current business models and 60% wanted more risk disclosure.

However, certain types of disclosures apparently did work: EY reported that more respondents viewed company reports with “sector or industry-specific reporting criteria and key performance indicators” as “very beneficial,” compared with any other category of reporting, followed by “statements and metrics on expected future performance and links to nonfinancial risks.”

SideBar: In that regard, companies might turn to organizations such as the Sustainability Accounting Standards Board (SASB), which, starting in 2013, began to develop sets of voluntary sector-specific standards for disclosure in periodic reports on ESG issues — such as energy, climate change, drug safety and corruption and bribery — for the health care sector. Standards for other sectors followed, ultimately reaching 79 industry sectors. The purpose was to create an “infrastructure” that allowed companies to understand the issues that were likely to be material in their particular industries and to disclose specific risks and metrics that would enable peer-to-peer performance benchmarking. For example, one health care company was reported to have disclosed in its periodic report that there were risks associated with counterfeit medicines and, to address that risk, it had added serial numbers to certain products, resulting in a substantial reduction in reports of counterfeit medicine. Recently, SASB has introduced a “Field Guide,” a manual that includes SASB’s standards developed specifically for particular sectors; for each of the 79 industries, SASB examines “its sustainability challenges, the financial impacts those challenges pose, a summary of the state of disclosure, and other key stats.” SASB also offers “The Annual State of Disclosure Report,” which benchmarks “the state of sustainability disclosure” in numerous SEC filings across 79 industries. The Global Reporting Initiative has also developed sustainability reporting standards with sector-specific supplements.

EY suggests that the prevalence of high-profile social and environmental incidents, along with the Paris Climate Accord, will drive further increases in ESG disclosures. EY recommends that companies attempt to meet investor expectations by taking a long-term view, considering “global megatrends,” disclosing climate risks and how the company expects to address them, and allocating capital and infrastructure to ESG. EY also advises that companies tell their stories by first understanding the opportunities inherent in managing ESG risk, highlighting the company’s understanding to investors, engaging with various constituents and the board and integrating the company’s reporting. Finally, EY suggests that companies be transparent about the challenges by disclosing all material risks and their potential impact, EY also recommends that companies consider independent third-party assurance.

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